If you’ve spent any time on our website or talking with one of our counselors, you know how important a debt-to-income ratio can be. This tool, often used by lenders, can also help us evaluate the health of our individual financial situations. The formula is simple; all you have to do is divide your total debt by your total income and then convert the decimal to a percentage. For a monthly look, take your monthly debt and income figures and use those instead. Oh, and even though the method is simple, we still have a calculator to make it even easier for you. What’s less simple, however, is understanding the significance of your ratio and what it can mean for your overall finances.
Three Levels of Debt-to-Income Ratios
In the credit counseling world, we think of a debt-to-income ratio as being divided into three main tiers. It’s a lot like a traffic light, with a green (safe), yellow (caution), and red (danger) level. We think that being at or under 15 percent is safe, between 15 and 20 is getting into risky territory, and above 20 percent is a dangerous level. And just to clarify, we are talking about non-mortgage debt here (more on mortgage ratios below).
Tier 1 – 15 Percent
At 15 percent, you will have enough remaining income to devote to things like housing, food, transportation, and so on. In fact, here’s a look at how this can all come together in an ideal situation (this chart is based on net income):
If something unexpected were to pop up, you might also be better prepared if your debt-to-income ratio and overall spending plan looked like this. Of course, we hope you have a healthy emergency savings fund set aside, but even if you were forced to take on new debt as a result of something unexpected, you would probably be OK due to already having it at such a manageable level of 15 percent.
For reference, an annual income of $35,000 comes out to a monthly income of about $2,917. A debt-to-income ratio of 15 percent would mean your total non-mortgage debts costs $437.50 or less each month.
Tier 2 – 15 to 20 Percent
The next tier is a debt-to-income ratio of between 15 and 20 percent. Using our previous example, if you make $35,000, a debt-to-income ratio of 20 percent means that your monthly debt costs $583.40. At this point, we often find that consumers are still okay and can keep their heads above water. Most likely, they will need to get on a self-pay method, such as the debt ladder or debt snowball and use their self-discipline to stay on top of their debts. But, some consumers might really begin to struggle at this level. After all, how did the debt-to-income ratio slip to this point to begin with. Is it due to an unforeseen event or a need to take out new credit? Is it due to a loss in income that has made minimum payments unbearable?
Slipping into this range could be a sign of more trouble to come. Because of this, we recommend that consumers take action at this point. In fact, we offer a free budget and credit counseling session that allows consumers to gain control of this situation. A counselor can help you determine if there is room in your budget to cut expenses and devote more money to your accounts or if your situation might be better suited for a Debt Management Program, especially if you are balancing multiple high-interest debts.
Tier 3 – 20 Percent and Above
Lastly, the tier of 20 percent and above is the most dangerous. For a base income of $35,000, a 25 percent debt-to-income ratio would mean that your monthly debts total $729.25! At this stage, it’s pretty clear that something isn’t quite right. You have more debt than you can really afford. This doesn’t mean that it’s impossible to make it on your own, but it will be tough. You should definitely talk to a credit counselor and see what your best options are.
What about for mortgages?
Debt-to-income ratios are much different when we think about mortgages. There are two terms related to mortgage and debt-to-income ratios that you should know: front-end and back-end.
A front-end ratio is the percentage of your income that would be devoted to housing costs. When a lender is determining whether they will offer you a loan at a given amount, they will take your gross income, multiply it by their required front-end ratio and come up with a total. This total will be the amount you can pay toward housing, and they may not award you a loan that would exceed this amount.
Here’s a quick example, using our hypothetical $35,000 salary and a maximum front-end ratio of 25 percent. We are using 25% because that’s the “ideal” amount to spend on housing, based on our spending plan above:
In this example, a lender would likely not want to award you a loan that would require you to pay more than $729 per month in housing costs. This assumes that the lender is using a 25 percent maximum and that their are no other income earners, such as a spouse, in the equation.
The lender will also multiply your gross income by the back-end ratio, which is a higher figure. The back-end ratio is higher because it includes your housing expenses along with all other debts. So, this includes the front-end and anything else, like credit cards and student loans. Again, this calculation will return a dollar figure, and your total debt commitments should not exceed it.
Another example, using a back-end ratio of 36 percent:
Thanks for Reading!
We hope that this post has been helpful to you and that you now have a better understanding of how to calculate and evaluate your debt-to-income ratio. All in all, you want to do anything in your power to get your debt-to-income ratio under 15 percent. And then, of course, our hope is that you pay off all your debt. For further reading, check out our post on how to become debt free in 5 simple steps, and if your debt-to-income ratio is cause for concern, learn more about how you can chat with a credit counselor at no-cost to you.